A

PROJECT REPORT
ON

INDIA:
BOP CRISIS-1991

SUBMITTED TO
PUNE UNIVERSITY
BY
ARUN KUMAR SHARMA
PGDFT
2009-2011

SINHGAD INSTITUTE OF BUSINESS ADMINISTRATION &

RESEARCH

S.NO. 40/4A + 4B/1, NEAR PMC OCTROI POST

KONDHWA-SASWAD ROAD, KONDHWA (BK), PUNE- 411048

1
 CERTIFICATE

This is to certify that ARUN KUMAR SHARMA student of SINHGAD INSTITUTE OF

BUSINESS ADMINISTRATION & RESEARCH, Pune has completed his final
project on the topic of “INDIA:BOP CRISIS-1991” and has submitted the project in
partial fulfillment of PGDFT of the UNIVERSITY OF PUNE for the academic year
2009-10.
He has worked under our guidance and direction. The said report is based on
bonafide information.

Prof. Manisha Landey Dr.V.S.Mangnale

Project Guide Director

Date:
Place: Pune

2
SINHGAD INSTITUTE OF BUSINESS ADMINISTRATION
AND RESEARCH, KONDHWA (BK)

DECLARATION

I herby declare that the project titled “INDIA: BOP CRISIS-1991” is an original piece
of project work carried out by me under the guidance and supervision of Prof. Manisha
Landey. The information has been collected from genuine & authentic sources. The work
has been submitted in partial fulfillment of the requirement of PGDFT to Pune
University.

Place: Signature:

Date: Arun Kumar Sharma

3
 Index

Sr.no Particulars Page.no

1 Introduction 5

2 BALANCE OF TRADE AND BALANCE 6

OF PAYMENTS

3 COMPONENTS OF BALANCE 7
OF PAYMENTS

4 10
Disequilibria in BOP

5 BOP crisis 1991 (Pre-Reforms Era) 11

6 What Caused the 1991 Currency Crisis 12

in India?

7 Conclusion 34

4
 INTRODUCTION
A balance of payment is a double entry system of record of all
economic transactions between the resident of the country and the rest of the
world carried out in a specific period of time. Balance Of Payments
Statement presents classified record of:

• All recipient on account of goods exported

• Services rendered
• Capital received by residents
• Payments made by the residents due to goods imported and services
received from
• Capital transferred to non-residents/foreigners.

The IMP publication on, ‘Balance of Payments Manual’, describes the

concept of balance of payments as:
The balance of payments is a statistical statement for a given period
showing:

• Transaction in goods and services and income between an economy

and the rest of the world.
• Changes of ownership and other changes in that country’s monetary
gold, SDRs, and claims on and liabilities to rest of the world, and
unrequited transfers and counterpart entries that are needed to balance,
in the accounting sense, any entries for the forgoing transactions and
changes which are not naturally offsetting.

5
BALANCE OF TRADE AND BALANCE OF
PAYMENTS

The balance of trade is a narrow term. It takes into account only

merchandise export s and imports. Thus, balance of trade takes into account
only the transactions arising out of the export and import of visible items. In
other words, balance of trade does not take into account the exchange of
invisible items like services of banking sectors, insurance sectors, transport
sectors, tourism industry, and dividend payments and receipt.

The balance of payment takes in to account the export and

import of both visible and invisible items. In other words, it takes into
consideration, the export and import of goods of all kinds including
consumer goods, consumer durables, fast moving consumer goods, capital
goods, machinery, technical instruments and services like banking,
insurance, tourism, transportation etc, and payments of salaries, benefits,
interests, dividends etc.

Thus, balance of payments is much wider terms as compared

to balance of trade. Balance of trade presents an account of comprehensive
economic and financial transactions of a country with the rest the globe.

6
COMPONENTS OF BALANCE OF
PAYMENTS
As indicated earlier, these are several items in balance of payments. These
items can be classified as hereunder:
• Current Account
• Capital Account
• Unilateral Payment Account
• Official Settlement Account.

CURRENT ACCOUNT:

Items under current account:

Credits Debits
1. Merchandise Exports(Sales Of 1. Merchandise Imports(Purchase
Goods) of Goods)
2. Invisible Exports(Sales of 2. Invisible imports(Purchase of
Services) Services)
• Transport services sold abroad • Transport services purchased
• Insurance services sold abroad from abroad
• Foreign tourists expenditure in • Insurance services purchased
the country from abroad
• Other services sold abroad • Tourists expenditure abroad
• Incomes received on loans and • Other services purchased from
investments abroad abroad
• Income paid on loans and
investments in the home
country
7
CAPITAL ACCOUNT:
Items under capital account:
Capital Account Credits
1. Foreign long-term investments
in home country(less
redemptions and repayments)
• Direct investments in the
home country
• Foreign investments in home
country
• Other investments of
foreigners in home country
• Foreign Governments loans to
the home country
2. Foreign short-term
investments in the home
country.
Unilateral Transfer Account
1. Private remittances received
from abroad
2. Pension payments received
from abroad
3. Government grants received
from abroad
Official Settlements Accounts
1. Official sales of foreign
currencies or other reserves
assets abroad.
Capital Account Debits
1. Long-term investments
abroad(less
redemptions and repayments)
• Direct investments abroad
• Investments in foreign
securities
• Other investments abroad
• Governments loans to the
Foreign country
3. Short-term investments
abroad.
Unilateral Transfer Account
1. Private remittances abroad
2. Pension payments abroad
3.Government grants abroad
Official Settlements Accounts
1. Official purchases of foreign
currencies or other service
assets.
8
UNILATERAL TRANSFER ACCOUNT

Unilateral transfers are ‘giving the gifts’. These includes government grants,
reparations, private remittances, disaster relief etc. India gave grant to
Uganda in 1998. This item would be on the debit side of India’s balance of
payments and credit side of Uganda’s balance of payment.

OFFICIAL TRANSFER ACCOUNT

Official settlements account represents the official sales of foreign

currencies and other reserves to foreign countries or official purchase of
foreign currencies or other reserves from foreign countries.

9
 Disequilibria in BOP

• BOP position is considered favourable, when receipts from foreigners,

exceed payments made to them and unfavourable when payments
exceeds receipts.
• Disequilibria is caused by random variations in trade, fluctuations in
production of primary goods resulting in unusual trade in such
commodities and are generally temporary in nature.
• Disequilibria in BOP can also occur as a result of:
o Technological improvements affecting quality & prices of some
products, in certain parts of the world, resulting in altering
pattern of trade.
o State of economic development of a nation.
o Drastic change in consumer tastes, as a result of improvements
in communication technologies, information system etc.
o Changes in income level of the people of the nation, as a result
of high growth rates, leading to a different level of consumption
pattern &higher imports.
o Inflation, thereby increasing the cost of output of a country,
also results in reduction in exports.

10
 BOP crisis 1991 (Pre-Reforms Era)

Historically, India had a negative trade balance since 1950-51,

excepting for 1972-73 & 1976-77, when there was a marginal positive trade
balance. The invisible accounts hardly contribute to a surplus & showed
marginal balances. The balance in the invisible account was $0.173 Bn. in
1960-61, $- 0.049Bn. in 1970-71, $5.065 Bn. in 1980-81 & $- 0.242 Bn. in
1990-91. This led to significant current account deficits in the late 80s
India’s BOP was vulnerable to external shocks.

Our foreign exchange reserves declined from $5.97 Bn. in 1985-

86 to $3.37Bn. in 1989-90 & the current account deficit which traditionally
used to be less than 2% of GDP had reached 2.93% of GDP in 1988-89.
Because of increased short term borrowings, interest burden nearly doubled
from $2.128.Bn. in 1988-89 to $4.12 Bn. in 1990-91. Our reserves
accounted for 1.6 months of imports in the year 1989-90. The gulf war in
1990, nearly doubled the crude oil price & our reserves got depleted to $2.24
Bn. in by the end of 1990-91. This covered less than 1 month import bill.

Substantial outflow of deposits by NRI’s added to the crisis.

Reserves declined further to $0.9 Bn. on 16th January. 1991 & current
account deficit as a percent of GDP shot up to 3.24% the GOI’s initial
response was to cut on imports & impose further control on consumption of
petroleum products. Import of most of the products, barring the extremely
essential ones, was made extremely difficult to conserve foreign exchange.

11
What Caused the 1991 Currency Crisis in India?
Which model best explains the 1991 currency crisis in
India? Did real overvaluation contribute to the crisis? This paper seeks the
answers through error correction models and by constructing the
equilibrium real exchange rate using a technique developed by Gonzalo and
Granger (1995). The evidence indicates that overvaluation as well as
current account deficits and investor confidence played significant roles in
the sharp exchange rate depreciation. The ECM model is supported by
superior out-of-sample forecast performance versus a random walk model.
[JEL F31, F32, F47]

In mid-1991, India’s exchange rate was subjected to a severe

adjustment. This event began with a slide in the value of the rupee leading
up to mid-1991. The authorities at the Reserve Bank of India slowed the
decline in value by expending international reserves. With reserves nearly
depleted, however, the exchange rate was devalued sharply on July 1 and
July 3 against major foreign currencies.
India’s 1991 crisis provides an interesting case study with
certain features that are distinct from popular theoretical models. Although
some elements were present, the crisis cannot adequately be described as a
first generation currency crisis model. It also didn’t follow the second
generation models, nor the more recent literature that emphasizes financial
sector weakness, overlending cycles, and contagion. In addition, despite
progress in liberalizing trade and capital flows, India is still relatively closed
and capital inflows have been well below those in other Asian economies.
Therefore, India’s 1991 crisis contrasts with the 1997 crisis that hit the very
open Asian countries.
First generation models of currency crisis (Krugman, 1979;
Flood and Garber, 1984) illustrate the collapse of an exchange rate peg
under monetization of government deficits. The collapse can occur quickly,
well before reserves have been depleted. The sudden collapse comes about

12
due to the perfect mobility of capital, which moves to maintain uncovered
interest parity. In a perfect foresight version of a first generation model,
instantaneous capital flows ensure that there are no jumps in the exchange
rate that would represent a profit opportunity for speculators.

When the shadow value of the exchange rate crosses the

fixed rate, there is a sudden loss of reserves and increase in interest rates,
and the currency begins to depreciate. In models with uncertainty, interest
rates rise before the attack, reflecting the higher probability of devaluation,
and the exchange rate can
jump.
India’s 1991 crisis cannot be explained well by the first
generation models due to India’s very restrictive capital controls. Prior to
1991, capital flows to India predominately consisted of aid flows,
commercial borrowings, and nonresident Indian deposits (Chopra and
others, 1995). Direct investment was restricted, foreign portfolio investment
was channeled almost exclusively into a small number of public sector bond
issues, and foreign equity holdings in Indian companies were not permitted.
While deposits to Indian banks by nonresident Indians were allowed,
restrictions were placed on the interest paid. Even in 1996, after some post-
crisis liberalization measures, India’s capital controls were among the most
restrictive in the world based on an index constructed from the IMF’s
annual
Report on Exchange Arrangements and Exchange Restrictions (Tamirisa,
1999). Montiel (1994) finds that India’s capital controls have been relatively
effective. Therefore, first generation models are not suitable depictions of
India’s crisis, nor, given its limited capital inflows, are models developed to
explain the 1997 Asian currency crisis, such as problems with
intermediation by the domestic banking system or overlending booms.
Another class of models focuses on exchange rate
misalignment and devaluation cycles in developing countries with capital
controls. These models share some features with the first generation models;
namely, expansionary fiscal policies are inconsistent with the pegged
exchange rate. With a closed capital account, however, the dismantling of
inconsistent policies occurs through the goods markets, rather than through
the asset markets as in the first generation models. Edwards (1989) presents
an extensive analysis of exchange rate misalignments and crises in
developing countries, including those with restricted external regimes. His
analysis distinguishes between traded and nontraded goods. Monetization of
large public deficits generates a higher domestic price level. Given a fixed
13
nominal exchange rate or a crawling peg set at a rate lower than inflation,
the real exchange rate appreciates and the trade balance deteriorates. Reserve
loss is gradual over a long period of time.

The exchange rate crisis occurs when reserves are finally

depleted or when they reach a lower bound set by the government. The
currency is devalued to a level that permits a trade surplus an reserve
accumulation for some time. With an unchanged fiscal policy that continues
to monetize high deficits, this model illustrates an ongoing cycle of reserve
loss and exchange rate misalignment, followed by devaluation and reserve
gain.
Flood and Marion (1997) consider the optimal size and
frequency of devaluations for a country that pegs its exchange rate,
maintains capital controls, and experiences real appreciation. Studying a
sample of Latin American countries, they find evidence that higher drift in
real appreciation shortens the life of the peg, but increases the size of
adjustment. Higher variance in the real exchange rate increases the time on a
peg and the adjustment size. India’s real exchange rate appeared to have
minimal drift and low variance. The model implies that the optimal size of
India’s devaluations should be small, but the optimal frequency of
adjustment would be ambiguous.
The Mundell-Fleming model describes exchange rate
adjustment under conditions of sticky prices.1 In the case of low capital
mobility, fiscal expansion leads to higher interest rates and output, and large
current account deficits that exceed capital inflows. The balance of payments
deficit can be corrected with a devaluation, which improves the trade
balance and also results in higher output and interest rates. Given sticky
prices, the real exchange rate is constant until the nominal devaluation
occurs, which generates an equivalent real devaluation.
Macroeconomic policies in India exhibited some
differences compared to Edwards’s model and to Latin American currency
crises. Although India was running high public deficits (Figure 1), the
financing of the deficits did not center on monetization. Some of the
financing was achieved through revenue from financial repression (Kletzer
and Kohli, 2001), but much of it came through borrowing, including from
external sources. Unlike the Latin cases in which monetization of deficits led
to extremely high rates of inflation, India’s inflation was broadly similar to
that of its trading partners. While India’s exchange rate was officially
pegged to a basket of currencies with small fluctuation margins prior to
14
1992, its trade-weighted nominal exchange rate and U.S. dollar rate
depreciated steadily over the second half of the 1980s.

This trend would require small frequent devaluations,

consistent with the Flood and Marion model. The rate of nominal
depreciation (Figure 2) was considerably faster than the relative inflation
differential and the real exchange rate depreciated as well (Figure 3).
Therefore, some of the conditions assumed by Edwards—high domestic
inflation in combination with a nominal exchange rate fixed to a low
inflation country—do not appear to have been met. Instead, nominal
exchange rate adjustment outpaced adjustment through the price level.

In official descriptions of the event, India’s exchange rate

crisis has been attributed to continued current account deficits leading up to
the crisis (Figure 4), made worse by problems related to the Gulf War; and a
loss of confidence in the government as political problems compounded the
weak credibility associated with high fiscal deficits.2 A more detailed
description of the shocks and external sector performance is provided in the
next section. India’s macroeconomic developments are generally consistent
with the traditional Mundell-Fleming model. An additional component of
the crisis involved rising debt levels (Figure 5), including from external
sources. Foreign exchange reserves had declined steadily since the
beginning of the 1980s, removing an important source for financing the
current account deficits and external debt (Figure 6). The convergence of
shocks in 1991 led to a liquidity crunch. Adjustment took the form of a
sharp rise in interest rates (Figure 7), coupled with the severe exchange rate
depreciation.
The remainder of the paper employs econometric
analysis to formally test the alternative explanations of India’s currency
crisis. As explained above, several currency crisis models are based on
expansionary fiscal policy which, when embedded in a model incorporating
traded and non-traded goods, leads to real exchange rate appreciation and an
eventual devaluation to correct the misalignment. In contrast, India’s real
exchange rate depreciated, despite the high fiscal deficits. However, other
factors may have been responsible for an equilibrium decline in the real
exchange rate that masked policy-induced over valuation. Therefore, the
paper proceeds by estimating the long-run (equilibrium) real exchange rate
15
for India in order to determine whether the Indian rupee was overvalued at
the time of the crisis in 1991. If the evidence suggests that the exchange rate
was misaligned, the aim is then to find the macroeconomic factors that led to
it.

I. Shocks and External Sector Performance

India’s post-Independence development strategy
was both inward-looking and highly interventionist, consisting of import
protection, complex industrial licensing requirements, financial repression,
and substantial public ownership of heavy industry. However,
macroeconomic policy sought stability through low monetary growth and
moderate public sector deficits. Consequently, inflation remained generally
low except in response to unfavorable supply shocks (e.g., from oil price
increases or poor weather conditions). The current account was in surplus
for most years until 1980, and there was a reasonable cushion of official
reserves.3 Official aid dominated capital inflows.
During the first half of the 1980s, the current
account deficit stayed below 11/2 percent of GDP. While export growth was
slow, the trade deficit was kept in check, as a rapid rise in domestic
petroleum production permitted savings on energy imports. At the same
time, the high proportion of concessional external financing kept debt
service down.
In the second half of the 1980s, current account
deficits widened. India’s development policy emphasis shifted from import
substitution toward export-led growth, supported by measures to promote
exports and liberalize imports for exporters. The government began a
process of gradual liberalization of trade, investment, and financial markets.
Import and industrial licensing requirements were eased, and tariffs replaced
some quantitative restrictions. Export growth was rapid, due to the initial
measures of deregulation and improved competitiveness associated with the
real depreciation of the rupee. However, the value of imports increased at a
faster clip. The volume of petroleum imports increased by more than 40
percent from 1986/87 to 1989/90 with the growth of domestic petroleum
production slowing and consumption growth remaining strong. A
deterioration of the fiscal position stemming from rising expenditures
contributed to the wider current account deficits. For instance, imports of
aircraft and defense capital equipment rose sharply. The balance on
invisibles also deteriorated as debt-service payments ballooned.

16
 Current account deficits in the second half of the
1980s exceeded the availability of aid financing on concessional terms and
consequently other sources of financing were tapped to a greater extent. In
particular, the growing current account deficits were increasingly financed
by borrowing on commercial terms and remittances of nonresident workers,
which meant greater dependence on higher cost short maturity financing and
heightened sensitivity to shifts in creditor confidence. India’s external debt
nearly doubled from some $35 billion at the end of 1984/85 to $69 billion by
the end of 1990/91. Medium- and long-term commercial debt jumped from
$3 billion at the end of 1984/85 to $13 billion at the end of 1990/91 and the
stock of nonresident deposits rose from $3 billion to $10.5 billion over the
same period. Short-term external debt grew sharply to $6 billion and the
ratio of debt-service payments to current receipts widened close to 30
percent. By 1990/91, India was increasingly vulnerable to shocks as a result
of its rising current account deficits and greater reliance on commercial
external financing.
Two sources of external shocks contributed the most
to India’s large current account deficit in 1990/91. The first shock came
from events in the Middle East in 1990 and the consequent run-up in world
oil prices, which helped precipitate the crisis in India. In 1990/91, the value
of petroleum imports increased by $2 billion to $5.7 billion as a result of
both the spike in world prices associated with the Middle East crisis and a
surge in oil import volume, as domestic crude oil production was impaired
by supply difficulties.

In comparison, non-oil imports rose by only 5 percent in

value (1 percent in volume terms). The rise in oil imports led to a sharp
deterioration in the trade account, worsened further by a partial loss of
export markets (as the Middle East crisis disturbed conditions in the Soviet
Union, one of India’s key trading partners). The Gulf crisis also resulted in a
decline in workers’ remittances, as well as an additional burden on
repatriating and rehabilitating nonresident Indians from the affected zones.

17
 Second, the deterioration of the current account was
also induced by slow growth in important trading partners. Export markets
were weak in the period leading up to India’s crisis, as world growth
declined steadily from 41/2 percent in 1988 to 21/4 percent in 1991. The
decline was even greater for U.S. growth, India’s single largest export
destination. U.S. growth fell from 3.9 percent in 1988 to 0.8 percent in 1990
and to –1 percent in 1991. Consequently, India’s export volume growth
slowed to 4 percent in 1990/91.
In addition to adverse shocks from external factors,
there had been rising political uncertainty, which peaked in 1990 and 1991.
After a poor performance in the 1989 elections, the previous ruling party
(Congress), chaired by Rajiv Gandhi (the son of former Prime Minister
Indira Gandhi), refused to form a coalition government. Instead, the next
largest party, Janata Dal, formed a coalition government, headed by V.P.
Singh. However, the coalition became embroiled in caste and religious
disputes and riots spread throughout the country. Singh’s government fell
immediately after his forced resignation in December 1990. A caretaker
government was set up until the new elections that were scheduled for May
1991. These events heightened political uncertainty, which came to a head
when Rajiv Gandhi was assassinated on May 21, 1991, while campaigning
for the elections.
India’s balance of payments in 1990/91 also
suffered from capital account problems due to a loss of investor confidence.
The widening current account imbalances and reserve losses contributed to
low investor confidence, which was further weakened by political
uncertainties and finally by a downgrade of India’s credit rating by the credit
rating agencies. Commercial bank financing became hard to obtain, and
outflows began to take place on short-term external debt, as creditors
became reluctant to roll over maturing loans. Moreover, the previously
strong inflows on nonresident Indian deposits shifted to net outflows.
The post-crisis adjustment program featured
macroeconomic stabilization and structural reforms. In response to the crisis,
the government initially imposed administrative controls and obtained
assistance from the IMF. Structural measures emphasized accelerating the
process of industrial and import delicensing and then shifted to further trade
liberalization, financial sector reform, and tax reform.

18
II. Theoretical Explanations of Equilibrium Real
Exchange Rates
This section discusses real fundamental determinants of the long-run real
exchange rate based on the theoretical models of Montiel (1997) and
Edwards (1989). Both works use intertemporal optimization techniques to
determine how the equilibrium real exchange rate is affected by real
variables. While Montiel’s model is an infinite horizon one, Edwards uses a
two-period optimization model. Intuitively, the equilibrium real exchange
rate—associated with the steady state in Montiel and the second period in
Edwards—is consistent with simultaneous internal and external balance. The
predictions from the two models can be summarized as follows:

• Changes in the composition of government spending affect the long-run

equilibrium real effective exchange rate (REER) in different ways,
depending on whether the spending is directed toward traded or non-traded
goods. If government spending is directed mainly toward traded goods and
services, the trade balance deteriorates. To bring the external balance in
equilibrium, the REER must depreciate. The expected sign on the coefficient
is negative. Conversely, spending directed mainly toward non-traded goods
and services generates excess demand in the non-traded sector. To restore
the sectoral balance, there must be an appreciation of the REER, which can
be defined in terms of the relative price of nontradables to tradables (an
increase in the ratio is defined as an appreciation). The expected sign on the
coefficient is positive.
• As the terms of trade improve, real wages in the export sector rise, drawing
in labor and leading to a trade surplus. To restore external balance, the
REER must appreciate. Hence, a positive coefficient is expected.
• As exchange and trade controls in the economy decrease, the demand for
imports leads to external and internal imbalances, which require real
depreciation to correct them. The expected sign depends on the proxy used
for exchange controls. Montiel uses the proxy openness
(exports+imports/gdp) for a reduction in exchange controls, arguing that as
trade barriers are reduced (including price and quantity controls), the total
amount of trade will increase. Accordingly, an increase in openness should
be associated with real depreciation, and the expected sign is negative.
However, Edwards uses other proxies for exchange controls—the ratio of

19
import tariff revenue to imports and the spread between the parallel and
official rates in the foreign exchange market. If these proxies are used, then
the expected sign is positive, since a reduction in the values of each of these
proxies implies a reduction in controls. Edwards stresses the limitations of
his two proxies. While import tariffs ignore the role of non-tariff barriers,
the spread between the parallel and official rates depends on some factors in
addition to trade controls.
• As capital controls decrease, private capital flows in and both the
intertemporal substitution effect and the income effect operate to increase
present consumption. There is pressure on the real exchange rate to
appreciate in the short run in order to induce greater production in the non-
traded sector and to shift some of the increased consumption toward imports.
However, the long-run effect of a reduction in capital controls is ambiguous.
The reduction in capital controls is equivalent to a decrease in the tax on
foreign borrowing that generates a positive wealth effect, which increases
consumption in all periods. Hence, an appreciation is required (positive sign)
for equilibrium to hold. On the other hand, by the intertemporal substitution
effect, future consumption is lower than present consumption, which exerts a
downward pressure on the future (long-run) price of nontradables, and hence
a depreciation of the REER is required (negative sign). The overall sign of
the equilibrium depends on which effect dominates.
• Balassa-Samuelson effect—technological progress: Higher differential
productivity growth in the traded goods sector leads to increased demand
and higher real wages for labor in that sector. The traded goods sector
expands, causing an incipient trade surplus. To restore both internal and
external balance, the relative price of non-traded goods must rise (REER
appreciation).
• Investment in the economy: According to Edwards, when investment is
included in the theoretical model, the intertemporal analysis includes supply-
side effects that depend on the relative ordering of factor intensities across
sectors. Therefore, the sign on the exchange rate in response to increased
investment is ambiguous.
Permanent changes in the fundamentals above bring
about changes in the long-run equilibrium real exchange rate. In other
words, strict purchasing power parity does not hold, as the equilibrium real
exchange rate is time varying. The real exchange rate therefore fluctuates
around a time-varying equilibrium defined by its relationship with the long-
run fundamental determinants.

20
 In addition to the long-run relationship, Edwards
considers macroeconomic policies that result in overvaluation of the
domestic currency, that is, short-run misalignments. He uses excess supply
of domestic credit and a measure of fiscal policy (ratio of fiscal deficit to
lagged high-powered money) as proxies of “inconsistent” macroeconomic
policies. As macroeconomic policies become highly expansive, the real
exchange rate appreciates—reflecting a mounting disequilibrium or real
exchange rate overvaluation. Hence, in connection with Edwards’s theory of
misalignment, variables for inconsistent macroeconomic policies are
included in the short-run part of the specification. In addition, the 1991 crisis
in India is believed to have been caused mainly by high fiscal deficits, the
loss of confidence in the government, and mounting current account deficits.
The next section attempts to verify these assertions through econometric
investigation.

21
III. Model Selection
This section estimates the intertemporal model
discussed above, using an error correction model (ECM). Before the
cointegration technique was developed, researchers used partial adjustment
or autoregressive models. These models assume that the variables are
stationary and try to capture the serial correlation in the endogenous variable
by including lags of it or by including ARMA terms. These techniques do
not account for the tendency of many economic variables to be integrated
and therefore also do not account for the possibility that the economic
variables share a common stochastic trend. Any equilibrium relationship
among a set of nonstationary variables implies that their stochastic trends
must be linked. Then, since these variables are linked in the long run, their
dynamic paths should also depend on their current deviations from their
equilibrium paths. The ECM has the advantage of capturing the common
stochastic trend among the nonstationary series and the deviations of each
variable from its equilibrium.
The variables used in the analysis are described
in the data appendix and a summary of their descriptive statistics is
presented in Table 1. The dependent variable for the models investigated
below is the log of the real effective exchange rate, calculated by the IMF.
The REER is a trade-weighted index using national consumer prices to
measure inflation. The weights take into account trade in manufactured
goods, primary commodities, and, where significant, tourist services. The
trade weights also reflect both direct and third-market competition. The
other variables are selected to represent the set of fundamental determinants
of the real effective exchange rate and a set of exogenous variables that are
thought to contribute to the short-run misalignment. The models described
below, with quarterly frequency, are estimated over the longest sample for
which all included variables are available in the period 1979 to 1997.
All of the variables are examined for unit
roots to suggest their stochastic behavior. The lag length is determined in a
backward selection process that starts with a maximum lag length of eight
quarters. Insignificant lags are sequentially dropped until the highest order
lag becomes significant. The deterministic components are included in the
test only if significant. Unit test results are reported in Table 2. Standard unit

22
root tests reveal that the null hypothesis of a unit root cannot be rejected for
the real exchange rate nor for any of its long-run fundamentals, but that it
can be rejected for the current account, excess credit, and the fiscal balance
to high-powered money. The inability to reject the unit root for the real
exchange rate could be interpreted as evidence against purchasing power
parity. The unit root test cannot be rejected for the index of political
confidence, but it can be rejected for its first difference.
The empirical strategy is to find a set of
significant long-run fundamentals and short-run explanatory variables and
use the analysis to distinguish between alternative theoretical explanations
for the behavior of India’s real exchange rate. The seven models are
described sequentially below. In summary, the first two models investigate
the long-run determinants of the REER; Models 3–6 explore alternative
specifications of the short-term factors; and Model 7 is a sensitivity test of
the long-run fundamental factors.
In accordance with the theory of error correction
models, the series are first tested for cointegration. The results from
cointegration tests using Johansen’s (1991) method are reported in Table 3,
including the number of cointegrating vectors. The lag length for the error
correction model is determined by backward selection, beginning at a lag
length of four to economize on degrees of freedom. The likelihood ratio test
indicates that an error correction model with two lags is the most appropriate
specification. The results reported in Table 4 are obtained by estimating the
ECM by imposing one cointegrating vector for ease of interpretation.
However, the equilibrium real exchange rate and forecasting analysis
discussed below are estimated with the number of cointegrating vectors
stipulated from the cointegration test.

We first estimate the ECM with all of the potential

fundamental long-run variables suggested from the theory (Model 1). The
results indicate that all the fundamentals are significant, except openness.
The same model was estimated with Edwards’s proxies for openness,
namely parallel market spread and exchange controls. However, they were
insignificant as well. Government consumption leads to a real depreciation,
consistent with a higher proportion of government consumption directed
toward traded goods relative to private consumption. An improvement in the
terms of trade leads to an appreciation of the real exchange rate, while
increases in openness and increases in investment lead to real depreciation.
A decrease in capital controls leads to higher capital inflows, which
appreciates the real exchange rate in the long run—indicating that the
23
income effect dominates over the intertemporal substitution effect.
Technological progress leads to an appreciated real exchange rate—a result
consistent with the Balassa- Samuelson effect.
Next, a general-to-specific modeling procedure is
employed. The insignificant variables from Model 1 are eliminated
sequentially to arrive at the parsimonious specification, Model 2. The results
remain the same as Model 1 in terms of signs, although the magnitudes
change slightly.
Having arrived at a parsimonious specification
involving significant fundamentals that affect the equilibrium exchange rate,
we now examine the impact of shortrun factors that can cause the exchange
rate to deviate temporarily from equilibrium. Model 3 is estimated with the
same long-run fundamentals as in Model 2, with proxies for inconsistent
macroeconomic policies as used by Edwards (1989).
The results indicate that the signs on the long-run
fundamentals remain the same as before and are significant. The coefficients
on the policy variables are insignificant—indicating that the empirical
evidence does not provide support for Edwards’s description of
misalignment in the case of India. Moreover, the signs of our results are
inconsistent with Edwards’s explanation of real exchange rate misalignment
in response to lax macroeconomic policy. Our (insignificant) results indicate
that an improvement in the government fiscal balance leads to an
appreciation in the real exchange rate and conversely, that fiscal deficits
correspond to a depreciation of the real exchange rate. Excessive domestic
credit creation results in a depreciation of the real exchange rate. In
Edwards’s model, the nominal exchange rate is fixed and higher government
deficits that are monetized give rise to a higher domestic price level and a
corresponding appreciation of the real exchange rate. Given these
assumptions, the lack of support for Edwards’s model for India is not
surprising: nominal depreciation of the rupee appears to have offset any
domestic price pressures arising from monetary expansion. In addition, the
data do not indicate that India monetized its deficits to any significant
extent.
The increasing fiscal deficits in the years leading up
to the crisis were financed by borrowing, including from foreign sources.
The effect of this was a misalignment in the external sector as a result of
fiscal deficits, which, at the prevailing levels, were inconsistent with an
intertemporal budget constraint. Instead of Edwards’s framework, the
exchange rate depreciation resulting from fiscal deficits or high domestic
credit creation is consistent with the classical Mundell-Fleming framework.
24
Expansive fiscal or monetary policy—in the case of a country such as India
with limited capital mobility—causes a balance of payments deficit and
nominal exchange rate depreciation. With sluggish prices, the real exchange
rate also depreciates.
Having found that the Edwards model does not fit
well for India, we now investigate whether the evidence supports the
descriptions of the causes of India’s balance of payments crisis; namely,
large current account deficits, fiscal deficits, and loss of confidence in the
government. Hence, to Model 2, we add the shortrun factors: the current
account balance, the government fiscal balance to high powered money (as
above), and changes in political confidence. The results are shown in column
4 of Table 4. The long-run results do not change much as the fundamentals
have the usual (significant) signs. Regarding the exogenous variables, both
the current account and the change in political confidence are significant,
with positive signs. This indicates that as the current account balance
improves and confidence in the government increases, the real exchange rate
appreciates. The sign and significance of the political confidence indicator
can be expected since this variable proxies for the confidence of India’s
creditors and their willingness to roll over debt or maintain deposits. Similar
to the result reported in Model 3, the government balance is positive but
insignificant. The insignificance of the fiscal variable here may be due to
collinearity. Confidence in the government is likely to decline as fiscal
deficits grow and appear unsustainable. Moreover, the inclusion of the
current account deficit in the equation, according to the Mundell-Fleming
model described above, captures the external effects of the expansionary
fiscal policy.
Through elimination of the insignificant fiscal variable,
we arrive at the parsimonious Model 5. However, one difficulty with using
this model for the analysis in the next sections is that data are available for
political confidence only from 1985. The loss of several years of data in the
early 1980s causes the problem that there are not enough degrees of freedom
to estimate a restricted sample for the outof- sample forecasting exercise
discussed below. Therefore, for purposes of the remaining analysis, the
political confidence variable is dropped and the baseline specification is
shown as Model 6—which consists of the long-run variables from the
parsimonious specification (Model 2) and the current account balance as the
exogenous short-run variable.
As a sensitivity analysis, we estimate Model 7, where
Edwards’s variables for capital control and investment are ignored but
openness and terms of trade are restored, consistent with Montiel’s
25
specification. The findings from Model 1 still hold—increases in
government consumption and openness lead to a depreciation of the real
exchange rate, while an improvement in the terms of trade results in an
appreciation of the real exchange rate.
An improvement in the current account balance brings
about real exchange rate appreciation. The coefficient on technological
progress, however, becomes insignificant.
One finding that emerges very clearly from the
econometric investigation is that the current account plays a very significant
role in explaining short-run movements in the real exchange rate for India
during the period of analysis. This variable is robust to all specifications (a
significant positive sign). This result is corroborated by Callen and Cashin
(1999), who examine the sustainability of India’s current account during the
period 1952/53–1998/99 using three methods. They find that in the period
prior to 1990/91, India’s intertemporal budget constraint was not satisfied
and that the return to smaller current account deficits following the crisis
was needed to reestablish solvency.
In this section, the current account has been discussed
as an exogenous shortrun explanatory variable. In general, however, the real
effective exchange rate could be expected to influence the current account.
Indeed, the decline in the real exchange rate in the latter half of the 1980s
was likely a contributing factor to rapid export growth in particular, although
the initial liberalization measures implemented to spur export-led growth are
also thought to have been important.
However, since the key feature of the current account
from the mid-1980s through the crisis in mid-1991 was its sharp
deterioration, it seems that the simultaneous rapid decline in the real
exchange rate over this same period had at most a mitigating influence.
There were many other factors that jointly overwhelmed any beneficial
influence of the real exchange rate and produced the substantial deterioration
in the current account. As mentioned in the introductory section, some of
these factors included the increasing dependence on foreign oil imports and
consequently the greater vulnerability to oil price shocks; strong domestic
demand as a result of both the initial liberalization efforts and deteriorating
fiscal balances, but weak foreign demand in the years leading up to and
including 1991; shocks to workers’ remittances; and higher interest
payments on external debt due to its higher cost structure and growing size.
Moreover, these observations on the relationship
between the real exchange rate and the current account in this period are
borne out by evidence from Granger causation tests (Table 5). The results of
26
Granger causation tests lend support to the idea that movements in the
current account had a strong impact on the real exchange rate, but that the
opposite did not hold.
The null hypothesis that the current account does not
Granger cause changes in the real effective exchange rate can be rejected at
the 10 percent confidence level for 4 and 8 quarter lags and (marginally) at
the 5 percent confidence level for 12 quarter lags. In the other direction of
causality, the hypothesis that changes in the real effective exchange rate do
not Granger cause the current account cannot be rejected for 8 and 12 lags.
This hypothesis can be (marginally) rejected at the 10 percent confidence
level for 4 lags. In the latter case, however, the sum of the lagged exchange
rate coefficients in the current account equation is positive, counter to
theoretical predictions that decreases in the real exchange rate should lead to
improved current account balances. This evidence is in line with the
discussion above that the current account balances were deteriorating at the
same time that the real exchange rate was declining substantially.

27
IV. Estimating the Equilibrium Real Exchange
Rate
In order to determine whether the Indian rupee
was overvalued prior to the crisis in 1991, we estimate the equilibrium real
exchange rate, using the error correction model estimated in Section III.
Frequently, researchers construct the equilibrium real exchange rate by
multiplying the cointegrating vector with the actual values of the
fundamentals. However, the fundamentals may have their own temporary
components, and by using the actual values of the fundamentals, the
construction of the equilibrium real exchange rate depends on these
temporary components, when it should not. Edwards (1989) recognizes the
problem with using actual values of the fundamentals to construct the
equilibrium exchange rate. He tries to solve this by means of two methods.
He does a Beveridge-Nelson decomposition of each fundamental series or,
alternatively, he uses moving averages of each fundamental series. He then
uses the constructed permanent component of each variable in his
equilibrium equation. These are potential suggestions for finding the
equilibrium fundamentals, as would be other methods of univariate
decomposition into permanent and temporary components.
This section estimates the equilibrium real
effective exchange rate, using three different methods. First, the permanent
components of the fundamentals are constructed, using a Hodrick-Prescott
filter and a 13-quarter (centered) moving average process as representative
smoothing methods. These methods are used for illustrative purposes only.
While these methods produce smooth fundamental series that are appealing
to the eye, there is no sound theoretical basis for these procedures. If simple
smoothing processes were enough to arrive at the equilibrium values for the
fundamental series, then the same smoothing processes could be employed
on the real exchange rate series to estimate the equilibrium real exchange
rate. But doing so would be devoid of economic theory such as that which
describes a relationship between the exchange rate and other economic
variables, a relationship that is estimated through an error correction model
in this paper. In addition, independently smoothing the fundamentals does
not take advantage of information arising from the interaction of the
variables.
28
 Gonzalo and Granger (1995) propose a more
appealing way of solving this econometric problem so that the permanent
(equilibrium) component of the endogenous variable of interest—in our
case, the exchange rate—could be constructed by means of the permanent
components rather than the actual values of the fundamental determinants. It
is done using the joint information in the error correction system rather than
preconstructing the equilibrium fundamental variables. Other procedures
advanced in the literature to address this issue include those of Quah (1992)
and Kasa (1992). However, these latter two decomposition methods present
the undesirable property that the transitory component Granger causes the
permanent component, leading a temporary shock to have permanent effects
on the actual aggregated series. Gonzalo and Granger derive a P-T
decomposition such that the transitory component does not Granger cause
the permanent component in the long run (i.e., the effects of transitory
shocks die out over time). They define the permanent and temporary
components so that only the innovations from the permanent component can
affect the long-run forecast. Innovations to the temporary components of all
of the endogenous variables, including the fundamental determinants, do not
affect the long-run “equilibrium” forecast. So, for our purposes, cyclical
deviations of the fundamentals will be removed in the construction of the
equilibrium exchange rate. In addition, all of the information required to
extract the permanent component is contained in the contemporaneous
observations.
The equilibrium exchange rate is estimated for the
baseline model (Model 6), using the three methods—the Hodrick-Prescott
filter and a moving average process for illustrative purposes, and the
theoretically attractive Gonzalo-Granger method (Figure 8). The equilibrium
exchange rate constructed by means of the Hodrick-Prescott filtered series
shows an overvalued exchange rate from 1985:2 through 1995:5, while the
one estimated by smoothing the series using the moving average shows an
overvaluation of the exchange rate from 1986:3 through 1994:4.
As mentioned above, these findings carry no theoretical value. In order to
estimate the exchange rate consistent with the fundamentals, we construct
the equilibrium using the Gonzalo and Granger method. Figure 8 shows the
result—the real effective exchange rate was overvalued for several years
prior to and through the crisis (from 1985:3 through 1993:1). Indeed, the
equilibrium path was below the actual path of the exchange rate for several
years of a downward trend, suggesting that the actual depreciation was
29
moving in the direction of restoring equilibrium, although the equilibrium
itself continued to move to lower levels.

In 1993, the equilibrium comes into line with the actual data for
the first time since the mid- 1980s. Thereafter, the equilibrium is
periodically above or below the actual, but there is no clear trend. In
summary, a strong result that emerges from all of these estimations is that
the real exchange rate for India was overvalued at the time of crisis in 1991.

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V. Forecasting the Real Exchange Rate
In order to test the forecasting performance of the
baseline model (Model 6), we make dynamic as well as static forecasts of
the real exchange rate. For both types of forecasts, the model is estimated for
the full sample period (through 1997:1) and for a restricted sample period
that ends at a point sufficiently earlier than the crisis such that there would
be time for adjustment (1989:4 is chosen as the end point). The parameters
from the error correction model estimated over each of these two sample
periods are used to form forecasts for the period 1990:1 through 1997:1.
While the static forecasts for the exchange rate are formed using actual data
for the lagged endogenous variables on the right-hand side of the ECM,
dynamic forecasts use actual data for the endogenous variables only up to
1989:4 and thereafter use forecasted data for all of the right-hand side
endogenous variables.
The series of real exchange rate forecasts are shown
in Figure 9 with 95 percent confidence bands. Figures 9a and 9b present the
dynamic forecasts and Figures 9c and 9d present the static forecasts for the
baseline Model 6. The static forecasts from full and restricted sample
parameters follow the actual exchange rate exceptionally closely. More
surprisingly, the dynamic forecasts also display trends and cycles that are
similar to the actual data. The dynamic forecast using parameters from the
restricted sample does a better job in prediction than the forecast using the
full sample parameters in the initial part of the forecast period, but the latter
provides a better forecast for the end of the period.
Dynamic forecasts are also constructed for
Model 2 in Figure 9e and 9f (which is the same as the baseline Model 6, but
without the current account). The exchange rate forecasts show a linear
downward trend. Compared with this, the forecasts from Model 6 show a
similar downward trend, but also show cyclical movements that mirror the
actual exchange rate. The better comparative performance of the model
containing the current account adds to the evidence that the current account
has been an important determinant of short-run exchange rate movements
for India.

31
 The forecasting performance of our baseline
model is compared with the forecasting performance of different random
walk models—in terms of their respective Mean Squared Errors (MSE). The
static random walk model is estimated as the usual random walk—the
forecast for time t is the actual value of the exchange rate prevailing at time
t–1. These forecasts are comparable to the static forecasts from the ECM, as
they both use the actual data from the period immediately preceding the
forecast.
Some “dynamic” random walk models are also
estimated so that they can be compared with our dynamic forecasts—which
do not use any new information after the period of estimation. A simple
dynamic random walk model forms a forecast for all future exchange rates
based on the value of the exchange rate at the end of the estimation period
(1989:4). The two dynamic random walk with trend models are comparable
to our dynamic forecasts, where the trend is estimated over the full and the
restricted sample periods. These trends are combined with the value of the
exchange rate prevailing in 1989:4 to construct the dynamic random walk
forecasts.
The MSE results from forecasting are reported in
Table 6. The results provide striking evidence that the forecasts from the
ECM perform better than the random walk models. The static forecasts from
the ECM models outperform the static random walk while the dynamic
forecasts from the ECM models, including those using parameters from the
restricted sample, outperform all of the dynamic random walk models.
VI. Conclusions This paper is concerned with explaining the 1991 crisis in
India and contains three related points of interest. First, the paper uses error
correction models to distinguish between alternative theoretical explanations
for the crisis. The error correction models are estimated based on
fundamentals that affect the long-run exchange rate and short-term variables.
In terms of fundamentals, the Indian rupee appreciates in the long run in
response to an improvement in terms of trade, technological progress, and a
relaxation of capital controls. The real exchange rate depreciates when
government spending (on tradable goods) increases, the economy opens up
and investment increases. The short-run variable, the current account, is
found to be significantly positive and robust to all specifications. The error
correction results suggest that the Mundell-Fleming model provides a better
explanation for exchange rate developments in India in this episode than do
first generation models or the Edwards (1989) explanation of exchange rate
misalignments in developing countries.
32
 The econometric evidence supports the position that the
current account deficits played a significant role in the crisis. It appears that
a confluence of exogenous shocks led to a loss in investor confidence and to
escalating debt-service burdens that erupted in a currency crisis.

Second, the theoretically attractive method of Granger

and Gonzalo (1995), which employs joint information from the error
correction model, is used to construct the equilibrium real exchange rate and
determine if overvaluation contributed to the crisis. The estimates do show
that the Indian rupee was overvalued at the time of crisis in 1991. Finally,
the forecasts from our ECM model outperform random walk models in out-
of-sample exercises.

33
 Conclusion
• This project is contents all about the situation of Balance of Payment
in India. It also describes the balance between Balance of Payment
and Balance of Trade. The important thing that I described in this
project is the crisis of “Balance of Payment” which was happen in
1991. Balance of Payment and Balance of Trade both terms are very
useful from the economic point of view of every country. So, every
country must try to maintain B.O.P. and B.O.T. to improve the
international trade and economic condition. I also describe the
disequilibria in BOP. Disequilibria is caused by random variations in
trade, fluctuations in production of primary goods resulting in unusual
trade in such commodities and are generally temporary in nature.

• Disequilibria in BOP can also occur the result of :-

1. State of economic development of a nation.
2. Drastic change in consumer tastes, as a result of improvements in
communication technologies, information system etc.
3. Changes in income level of the people of the nation, as a result of high
growth rates, leading to a different level of consumption pattern
&higher imports.
4. Inflation, thereby increasing the cost of output of a country, also
results in reduction in exports.

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35
BIBLIOGRAPHY

1. www.google.com
2. International Business- P. Subba Rao
3. Foreign Exchange Management- C. Jeevnand

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